Active or passive investing: What is the difference?

Funds come in many shapes and sizes, and try to achieve different things using their different approaches. There is a fundamental distinction to make between two of the overarching approaches to managing a fund – active and passive investing.

It's important to understand the differences between these investment philosophies which, to an extent, can be seen as polar opposites. In this article, we outline the key points of differentiation, as well as some of the pros and cons of each.

Please see our glossary for information on the financial terms used in this article. 

1. Active...

Actively managed funds are run by professional experts who make investment decisions on your behalf.

Each active fund will have its own specific investment objective – beating the average returns of a stockmarket or paying a growing level of income to its investors, for example. This should tally with what you want or need from investing, not least your attitude towards risk.

In line with what the fund sets out to achieve, managers will invest in a range of individual assets – company shares or government bonds, for example – that collectively comprise the assets of the fund, which individuals can then access in one single investment.

Active fund managers believe that by using analysis, research and proven investment processes to make informed decisions, it’s possible to outperform the market. Rather than following the herd, active managers aim to make better-than-average calls and, in turn, deliver better-than-average returns to those who invest in their fund.

Fund managers will charge for investing your money. If your investments are successful, the returns should have the potential to outweigh the costs of investing.

2. Passive...

In contrast to active funds, passively managed funds look to closely track the performance of a particular market benchmark or index.

The composition of a passive fund will therefore be closely aligned to the basket of assets that comprise that market index. For example, a passive fund of UK company shares might invest in the companies that comprise the FTSE 100 benchmark index in line with their relative weight in the index.

A passive fund, by design, should rise and fall in line with the market index that it tracks. While this reduces the risk that your investment will underperform relative to the overall market, it also means that it won't be able to meaningfully outperform in the same way an actively managed fund potentially can. Exchange-traded funds (ETFs), which track a given market index but trade like a stock throughout the day, are a popular form of passive investing.

Passive fund charges tend to be lower, sometimes much lower, than for active funds, because there is less 'added value' by the provider, in the form of expertise or research needed to pick individual assets.

3. What we believe...

At M&G we’re firm believers in the benefits of active management – but we also recognise that some investors will prefer lower-cost passive management.

In our view, both active and passive strategies can play a role in a well-balanced portfolio.

While the value of index-tracking funds will rise and fall in line with the broader market, a good active fund manager will be able to pursue opportunities that could perform well even if overall market values are falling.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. The views expressed here should not be taken as a recommendation, advice or forecast. We're unable to give financial advice. If you’re unsure about the suitability of an investment, please speak to a financial adviser.